 Financial Terms Covariance

# Definition of Covariance ## Covariance

A measure of the degree to which returns on two assets move in
tandem. A positive covariance means that asset returns move together; a
negative covariance means they vary inversely.

## Covariance

A statistical measure of the degree to which random variables move together.

# Related Terms:

## Serial covariance

The covariance between a variable and the lagged value of the variable; the same as
autocovariance.

## Correlation coefficient

A standardized statistical measure of the dependence of two random variables,
defined as the covariance divided by the standard deviations of two variables.

## Correlation coefficient

A statistic in which the covariance is scaled to a
value between minus one (perfect negative correlation) and plus one (perfect
positive correlation).

## Country beta

covariance of a national economy's rate of return and the rate of return the world economy
divided by the variance of the world economy.

## Homogenous expectations assumption

An assumption of Markowitz portfolio construction that investors
have the same expectations with respect to the inputs that are used to derive efficient portfolios: asset returns,
variances, and covariances.

## Magic of diversification

The effective reduction of risk (variance) of a portfolio, achieved without reduction
to expected returns through the combination of assets with low or negative correlations (covariances).
Related: Markowitz diversification ## Portfolio variance

Weighted sum of the covariance and variances of the assets in a portfolio.

## Serial bonds

Corporate bonds arranged so that specified principal amounts become due on specified dates.
Related: term bonds.

## Term bonds

Often referred to as bullet-maturity bonds or simply bullet bonds, bonds whose principal is
payable at maturity. Related: serial bonds

## 45-Degree Line

A line representing equilibrium in the goods and services market, on a diagram with aggregate demand on the vertical axis and aggregate supply on the horizontal axis.

## Abnormal returns

Part of the return that is not due to systematic influences (market wide influences). In
other words, abnormal returns are above those predicted by the market movement alone. Related: excess
returns.

## Account Value

The sum of all the interest options in your policy, including interest.

## Accumulated Value

An amount of money invested plus the interest earned on that money.

## Acquisition of assets

A merger or consolidation in which an acquirer purchases the selling firm's assets.

The net present value analysis of an asset if financed solely by equity
(present value of un-levered cash flows), plus the present value of any financing decisions (levered cash
flows). In other words, the various tax shields provided by the deductibility of interest and the benefits of
other investment tax credits are calculated separately. This analysis is often used for highly leveraged
transactions such as a leverage buy-out. ## Allocation base A measure of activity or volume such as labour

hours, machine hours or volume of production
used to apportion overheads to products and
services.

## approximated net realizable value at split-off allocation

a method of allocating joint cost to joint products using a
simulated net realizable value at the split-off point; approximated
value is computed as final sales price minus
incremental separate costs

## Asset

Any possession that has value in an exchange.

## Asset

A resource, recorded through a transaction, that is expected to yield a benefit to a
company.

## Asset

Something that is owned; a financial claim or a piece of property that is a store of value.

## Asset

Probable future economic benefit that is obtained or controlled by an entity as a result of
a past transaction or event.

## asset

Anything owned by, or owed to, an individual or business which has commercial or exchange value (e.g., cash, property, etc.).

## Asset

All things of value owned by an individual or organization.

## Asset activity ratios

Ratios that measure how effectively the firm is managing its assets.

## Asset allocation decision

The decision regarding how an institution's funds should be distributed among the
major classes of assets in which it may invest.

## Asset-Backed Securities

Bond or note secured by assets of company. ## Asset-backed security

A security that is collateralized by loans, leases, receivables, or installment contracts
on personal property, not real estate.

## Asset-based financing

Methods of financing in which lenders and equity investors look principally to the
cash flow from a particular asset or set of assets for a return on, and the return of, their financing.

## Asset-Based Financing

Loans granted usually by a financial institution where the asset being financed constitutes the sole security given to the lender.

## Asset classes

Categories of assets, such as stocks, bonds, real estate and foreign securities.

## Asset Coverage

Extent to which a company's net assets cover a particular debt obligation, class of preferred stock, or equity position.

## Asset-coverage test

A bond indenture restriction that permits additional borrowing on if the ratio of assets to
debt does not fall below a specified minimum.

## Asset/equity ratio

The ratio of total assets to stockholder equity.

## Asset for asset swap

Creditors exchange the debt of one defaulting borrower for the debt of another
defaulting borrower.

## Asset/liability management

Also called surplus management, the task of managing funds of a financial
institution to accomplish the two goals of a financial institution:
1) to earn an adequate return on funds invested, and
2) to maintain a comfortable surplus of assets beyond liabilities.

## asset mix

The weighting of assets in an investment portfolio among different asset classes (e.g. shares, bonds, property, cash, overseas investments.

## Asset pricing model

A model for determining the required rate of return on an asset.

## Asset pricing model

A model, such as the Capital asset Pricing Model (CAPM), that determines the required
rate of return on a particular asset.

## Asset-specific Risk

The amount of total risk that can be eliminated by diversification by
creating a portfolio. Also known as company-specific risk or
unsystematic risk.

## Asset substitution

A firm's investing in assets that are riskier than those that the debtholders expected.

## Asset substitution problem

Arises when the stockholders substitute riskier assets for the firm's existing
assets and expropriate value from the debtholders.

## Asset swap

An interest rate swap used to alter the cash flow characteristics of an institution's assets so as to
provide a better match with its iabilities.

## Asset turnover

The ratio of net sales to total assets.

## asset turnover

a ratio measuring asset productivity and showing the number of sales dollars generated by each dollar of assets

## asset turnover ratio

A broad-gauge ratio computed by dividing annual
sales revenue by total assets. It is a rough measure of the sales-generating
power of assets. The idea is that assets are used to make sales, and the
sales should lead to profit. The ultimate test is not sales revenue on
assets, but the profit earned on assets as measured by the return on
assets (ROA) ratio.

## Assets

A firm's productive resources.

## ASSETS

Anything of value that a company owns.

## Assets

Items owned by the company or expenses that have been paid for but have not been used up.

## Assets requirements

A common element of a financial plan that describes projected capital spending and the
proposed uses of net working capital.

## Average (across-day) measures

An estimation of price that uses the average or representative price of a

## Benefit Value

The amount of cash payable on a benefit.

## Bond value

With respect to convertible bonds, the value the security would have if it were not convertible
apart from the conversion option.

## Book Returns

Book yield is the investment income earned in a year on a portfolio of assets purchased over a number of years and at different interest rates, divided by the book value of those assets.

## Book value

A company's book value is its total assets minus intangible assets and liabilities, such as debt. A
company's book value might be more or less than its market value.

## BOOK VALUE

An asset’s cost basis minus accumulated depreciation.

## Book Value

The value of an asset as carried on the balance sheet of a
company. In reference to the value of a company, it is the net worth
(equity) of the company.

## Book value

An asset’s original cost, less any depreciation that has been subsequently incurred.

## book value

Net worth of the firm’s assets or liabilities according
to the balance sheet.

## book value and book value per share

Generally speaking, these terms
refer to the balance sheet value of an asset (or less often of a liability) or
the balance sheet value of owners’ equity per share. Either term emphasizes
that the amount recorded in the accounts or on the books of a business
is the value being used. The total of the amounts reported for
owners’ equity in its balance sheet is divided by the number of stock
shares of a corporation to determine the book value per share of its capital
stock.

## BOOK VALUE OF COMMON STOCK

The theoretical amount per share that each stockholder would receive if a company’s assets were sold on the balance sheet’s date. Book value equals:
(Stockholders’ equity) / (Common stock shares outstanding)

## Book value per share

The ratio of stockholder equity to the average number of common shares. Book value
per share should not be thought of as an indicator of economic worth, since it reflects accounting valuation
(and not necessarily market valuation).

## Book Value per Share

The book value of a company divided by the number of shares
outstanding

an activity that is necessary for the operation of the business but for which a customer would not want to pay

## capital asset

an asset used to generate revenues or cost savings
by providing production, distribution, or service capabilities
for more than one year

## Capital asset

A fixed asset, something that is expected to have long-term usage within
a company, and which exceeds a minimum dollar amount (known as the capitalization
limit, or cap limit).

## Capital asset pricing model (CAPM)

An economic theory that describes the relationship between risk and
expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk
that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification.
The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security

## Capital Asset Pricing Model (CAPM)

A model for estimating equilibrium rates of return and values of
assets in financial markets; uses beta as a measure of asset risk
relative to market risk

## capital asset pricing model (CAPM)

Theory of the relationship between risk and return which states that the expected risk
premium on any security equals its beta times the market risk premium.

## CAPITAL IN EXCESS OF PAR VALUE

What a company collected when it sold stock for more than the par value per share.

## Capitalized Cost An expenditure or accrual that is reported as an asset to be amortized against

future-period revenue.

Book value.

## CARs (cumulative abnormal returns)

a measure used in academic finance articles to measure the excess returns an investor would have received over a particular time period if he or she were invested in a particular stock.
This is typically used in control and takeover studies, where stockholders are paid a premium for being taken over. Starting some time period before the takeover (often five days before the first announced bid, but sometimes a longer period), the researchers calculate the actual daily stock returns for the target firm and subtract out the expected market returns (usually calculated using the firm’s beta and applying it to overall market movements during the time period under observation).
The excess actual return over the capital asset pricing model-determined expected return market is called an ‘‘abnormal return.’’ The cumulation of the daily abnormal returns over the time period under observation is the CAR. The term CAR(-5, 0) means the CAR calculated from five days before the
announcement to the day of announcement. The CAR(-1, 0) is a control premium, although Mergerstat generally uses the stock price five days before announcement rather than one day before announcement as the denominator in its control premium calculation. However, the CAR for any period other than (-1, 0) is not mathematically equivalent to a control premium.

## Cash-surrender value

An amount the insurance company will pay if the policyholder ends a whole life
insurance policy.

## Cash Surrender Value

This is the amount available to the owner of a life insurance policy upon voluntary termination of the policy before it becomes payable by the death of the life insured. This does not apply to term insurance but only to those policies which have reduced paid up values and cash surrender values. A cash surrender in lieu of death benefit usually has tax implications.

## Cash Surrender Value

Benefit that entitles a policy owner to an amount of money upon cancellation of a policy.

A method of investment appraisal that calculates the ratio of the net present value of an
investment to the initial capital investment.

## Conflict between bondholders and stockholders

These two groups may have interests in a corporation that
conflict. Sources of conflict include dividends, distortion of investment, and underinvestment. Protective
covenants work to resolve these conflicts.

## Continuous random variable

A random value that can take any fractional value within specified ranges, as
contrasted with a discrete variable.

## Contra-asset account

An offset to an asset account that reduces the balance of the asset account.

## Conversion value

Also called parity value, the value of a convertible security if it is converted immediately.

## Current asset

Typically the cash, accounts receivable, and inventory accounts on the
balance sheet, or any other assets that are expected to be liquidated within a short
time interval.

## Current assets

value of cash, accounts receivable, inventories, marketable securities and other assets that
could be converted to cash in less than 1 year.

## Current assets

Cash, things that will be converted into cash within a year (such as accounts receivable), and inventory.

## Current assets

Amounts receivable by the business within a period of 12 months, including bank, debtors, inventory and prepayments.

## current assets

Current refers to cash and those assets that will be turned
into cash in the short run. Five types of assets are classified as current:
cash, short-term marketable investments, accounts receivable, inventories,
and prepaid expenses—and they are generally listed in this order in
the balance sheet.

## Current Assets

Cash and other company assets that can be readily turned into cash within one year.

## decision variable

an unknown item for which a linear programming
problem is being solved

## Deferred Tax Asset

Future tax benefit that results from (1) the origination of a temporary difference
that causes pretax book income to be less than taxable income or (2) a loss, credit, or other
carryforward. Future tax benefits are realized on the reversal of deductible temporary differences
or the offsetting of a loss carryforward against taxable income or a tax-credit carryforward against
the current tax provision.

## degree of operating leverage

a factor that indicates how a percentage change in sales, from the existing or current
level, will affect company profits; it is calculated as contribution
margin divided by net income; it is equal to (1 - margin of safety percentage)

## degree of operating leverage (DOL)

Percentage change in profits given a 1 percent change in sales.

## dependent variable

an unknown variable that is to be predicted
using one or more independent variables

## Discrete random variable

A random variable that can take only a certain specified set of discrete possible
values - for example, the positive integers 1, 2, 3, . . .

## Dynamic asset allocation

An asset allocation strategy in which the asset mix is mechanistically shifted in
response to -changing market conditions, as in a portfolio insurance strategy, for example.

Operating profit, adjusted to remove distortions caused by certain accounting rules, less a charge
to cover the cost of capital invested in the business.

a measure of the extent to which income exceeds the dollar cost of capital; calculated
as income minus (invested capital times the cost of capital percentage)

Term used by the consulting firm Stern Stewart for profit remaining after deduction of the cost
of the capital employed.

## Endogenous variable

A value determined within the context of a model.

## Excess returns

Also called abnormal returns, returns in excess of those required by some asset pricing model.

## Exchange of assets

Acquisition of another company by purchase of its assets in exchange for cash or stock.

## Exercise value

The amount of advantage over a current market transaction provided by an in-the-money
option.

## Exit value

The value that an asset is expected to have at the time it is sold at a predetermined
point in the future.

## Exogenous variable

A variable whose value is determined outside the model in which it is used. Also called
a parameter.

## Expected value

The weighted average of a probability distribution.

## Expected Value

The value of the possible outcomes of a variable weighted by the
probabilities of each outcome

## Expected value of perfect information

The expected value if the future uncertain outcomes could be known
minus the expected value with no additional information.

## Extraordinary positive value

A positive net present value.